A close look at the ’86 tax reform shows why tax reform may not get done this year. As BofAML's Ethan Harris notes, “we are skeptical.” Significant tax reform creates winners and losers, which may make it hard to find a “coalition of the willing.”
Is it a done deal?
By some accounts, tax reform is more or less a done deal. After all, Republicans control both the executive and legislative branches of government so reform could pass without one Democrat vote. In particular, Republicans can use the “reconciliation” process to avoid a filibuster and pass a plan with just 51 votes in the Senate. House Republicans already have a specific plan and the President has already suggested a less fleshed out alternative. The leadership in the House is planning to focus first on repealing the Affordable Care Act (ACA), then writing the tax reform bill after the spring budget passes and enacting the plan by the August recess.
We are skeptical: even with the Republican sweep last fall, tax reform could prove taxing. Any reform requires that some groups give up hard won tax breaks in exchange for lower rates. This creates a complex web of winners and losers, causing splits both across parties and within parties. Here, we draw nine history lessons from the 1986 tax reform.
Nine reasons tax reform is tough
#1 A proclivity for Swiss cheese: The US political system, with the strong influence of lobbyists, seems to have a natural tendency to add complications to the tax code. Loopholes had been steadily added to the tax system in the run-up to 1986 reform, and loopholes have been creeping back into the tax code ever since the reform. Also recall that the ’86 reform put the top rate at 28%, but it has since climbed back to 39.6%. Turning our “Swiss cheese” tax system into “American cheese” will likely be difficult.
#2 Less compelling: Tax reform in 1986 had strong appeal to members of both parties. Republicans could point to the very high top tax rate of 50%. Democrats could point to a growing array of loopholes that mainly favored the rich. Top on that list was the ability to use losses from real estate and other “passive” income to offset salaries and other “active” income. The challenge we see today is that there are fewer loopholes to fill, making reform a much harder sell to Democrats.
#3 United leadership: A consistent theme from the people who worked on the 1986 reform was the importance of having a strong team of leaders committed to the process. Indeed, during key moments in the ’86 negotiation, Reagan stepped in to offer strong support for the effort. A lot of the work was done behind the scenes by a “gang of seven” Republican and Democratic Senators. Each had a strong stake in the success of the effort. Given the current partisan atmosphere in Congress, passage may require almost no defections by Republican members. We also wonder if the President and Republican leaders in the Senate and House will be able to present a united front against attempts to reintroduce loopholes.
#4 Deficit neutral: President Reagan made clear he wanted a deficit neutral plan and that is what he got. The 1986 law was considered deficit neutral even in static estimates; that is, without accounting for any stimulus to the economy. The idea of deficit neutrality was a way to bring discipline to the negotiations: any time someone pushed for reinstating a tax break they were pressed to offer a substitute. By contrast, the estimated 10-year deficit impact of the current House proposal is between $2.4tr (Tax Foundation) and $3.1tr (Tax Policy Center). The plan is only roughly deficit neutral using the aggressive dynamic scoring of the Tax Foundation. This could raise concerns from deficit hawks, including a number of Republicans.
#5 Corporate finance: Getting the ’86 bill through required trade-offs. The cuts in personal tax rates were partly paid for with increases in corporate taxes and several of the tax changes tended to discourage capital investment. In addition, on the personal side, the ’86 reform raised the tax rate for capital gains to match the 28% personal rate and created limits on IRAs. In other words, it is hard to “pay for” a “pure” tax plan that does not involve some growth-unfriendly elements. This could pit purists on taxes against purists on the budget deficit.
The other four lessons are about how hard it is to get a “coalition of the willing.” This requires balancing deficit concerns, views on the progressivity of the tax system, views of which industries and states should be favored, and attitudes toward international trade.
#6 Corporate complexity creates conflict: Compared to current proposals, the ’86 reform involved a relatively simple trade-off of lower tax rates for reduced loopholes. Today, House Republicans are attempting a deeper reform. Four changes in the corporate code are particularly notable in this respect: border adjustment, immediate expensing of capital, elimination of the net interest deduction and the repatriation tax. Each of these changes creates winners and losers, will likely be subject to intense lobbying pressure and could split support even within the Republican Party.
#7 Income distribution: A key selling point for the 1986 reform is that it did not attempt to alter the progressivity of the tax system—the impacts were roughly the same for lower- and upper-income people. By contrast, using “static” scoring, today’s House plan creates much bigger cuts for upper income families than for low income families. For example, after-tax income for the average family goes up only 0.7% to 2.4%, but 5.3% to 13.4% for the top 1% of families, according to the TF and TPC respectively. The benefits are more equally shared under dynamic scoring by the Tax Foundation, but not for other aggressive scorers. This will make it hard to get advocates of progressive taxation to support the proposal.
#8 State impacts: While the House proposal retains deductibility for mortgage interest and charity, it ends the deductibility of state and local income and property taxes. Recall that the 1986 reform initially eliminated the deductibility of state and local taxes but in the end only sales taxes were no longer deductible. Elimination of this key deduction, could impact support for the plan in states with high income taxes. Keep in mind that the 10 states with the highest state income taxes send 42 Republicans to the House and 5 to the Senate.
#9 Blocked at the border? One of the most controversial components of the bill, even within the Republican Party, is the border adjustment tax. This tax is effectively a tariff on imports and a subsidy to exports. It is critical to the bill because it raises $1.2 trillion in revenues over the next 10 years. Without it, even with very aggressive “dynamic scoring”, the tax bill would significantly increase the budget deficit. On the other hand, it faces considerable questions. It has triggered competing lobby groups: on one side, 100 retailers called “Americans for Affordable Products” oppose the tax; lined up on the other side, 16 companies comprising the “American Made Coalition” support the tax. Senator Hatch, Chair of the Senate’s Committee on Finance, has said he has “questions” on the tax in terms of who will bear it, whether it is “consistent with our international trade obligations,” and its impact in shifting the tax burden across industries. Three other Senate Republicans “have expressed concern that the proposal helps pick winners and losers.”
Nothing is certain but uncertainty
The bottom line is that a wide range of outcomes are possible this year, with very different implications for the economy. At one extreme, tax reform may not pass until very late in the year or not pass at all. This would likely delay any tax-related pick-up in growth and could even undercut current GDP forecasts as uncertainty about what will survive grows. At the other extreme, “tax reform” could devolve into essentially a big “tax cut” with no real attempt to prevent a bigger budget deficit. And in the middle, tax reform could pass, but in a highly watered-down form. Our base case assumes such a result, with legislation passed at year-end that excludes the border adjustment tax and makes up for the lost revenue by watering down a number of cuts. These could include partial rather than full expensing of capital, partial rather than full repeal of the inheritance tax, a less generous standard deduction, a more modest cut in marginal rates, etc.